Time to abandon traditional withdrawal rate in retirement A rule of thumb is valuable in estimating retirement spending, but only if it remains accurate, writes finance specialist Annika Bradley.
T
he 4 per cent rule is a generally accepted rule of thumb to help retirees determine a safe level of annual income to ensure nest eggs last. But given the current environment of low interest rates and high equity valuations, it’s time to revise that rate. It’s also time to expand the retirement income toolbox, beyond this rule of thumb, to give the many Australians embarking on retirement the confidence to spend their hard-earned savings.
What is the 4 per cent rule? Back in 1994, financial planner William Bengen conducted a study to find a starting withdrawal level (with the initial dollar amount adjusted thereafter for inflation) that could be sustained over every 30-year rolling time period since 1926. This was the genesis of the 4 per cent rule. It found that retirees invested in a balanced portfolio (an equal mix of stocks and bonds) could safely withdraw 4 per cent of their original assets, adjusted for inflation, for 30 years and not run out of money. The 4 per cent rule is convenient and fits neatly into Australia’s financial planning infrastructure. It effectively takes an investment portfolio constructed for the saving (or accumulation) phase of retirement, tweaks the
mix of stocks and bonds, and then ‘sets and forgets’ the level of spending each year. It keeps a very complex problem simple.
What’s wrong with the 4 per cent rule? It’s too simple. It doesn’t optimise for a retiree who may: live for a shorter or longer period than 30 years (longevity risk); wish to spend more in the early years of retirement; is unable to stomach market ups and downs, or holds significant levels of home equity. Exhibit 1 demonstrates the outcomes of the first three scenarios using a very simplified set of assumptions in an Australian context. It ignores the impact of the Age Pension, which provides a safety net as superannuation savings and investment assets are consumed. While the Age Pension provides a significant safety net for retirees who desire income in excess of this minimum level, Exhibit 1 shows that the 4 per cent rule leaves retirees reliant on two main levers: market returns and spending levels. Granted, markets have done a stellar job underwriting most retirees’ spending, but their future path is unknown and not all retirees can tolerate market risk.
Exhibit 1: Simplified scenarios under the 4 per cent rule – an Australian context
Exhibit 1 ignores the impact of the Age Pension (part or full); it assumes that an Australian couple’s starting amount is $697,589 based on Australian Superannuation Fund Association’s (ASFA) average balances for males and females between age 65-69; the withdrawal amount is the ASFA Comfortable Standard as at 30 September 2021 for couples aged 65-84 who own their own home; the withdrawal is made at the start of the period; the inflation rate is set at the mid-point of the Reserve Bank of Australia’s inflation target (2% - 3%); the market return is assumed to equate to 4% p.a. for 30 years based on an equal mix of growth and defensive assets (based on the paper Past Performance as a Reliable Indicator: What return expectations suggest for future investor returns).
12
The problem with a rule of thumb is there is often a lot of variation for the individual experience and it doesn’t suit everyone. Morningstar’s US team recently conducted a study, The State of Retirement Income, which looked at the lowest and highest starting safe withdrawal rates over history using
YourLifeChoices Retirement Affordability Index™ February 2022
